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The Alibaba stock (NYSE:BABA) has yet to stage a sustained rally despite positive developments to one of its most prominent downside risks – namely, delisting – in recent weeks. Instead, it has become a constituent in the constant “tug-of-war” between gradual uptrends on positive news developments and violent declines on the first hints of weakness, with neither side staging a clear win.
The recent trend of short-lived gains and losses underscores investors’ angst over the Alibaba stock’s outlook still, despite greater clarity today on regulatory and macro headwinds compared to a year ago when the slump in U.S.-listed Chinese equities first began. Adding to our ongoing series of coverage on the stock, the following analysis will zero-in on what PCAOB inspections are, how they impact Alibaba, and what the latest protocol agreed between associated regulators – namely the CSRC, SEC and the PCAOB – mean for the shares’ valuation outlook in the NYSE.
What is HFCAA and How Does it Impact Alibaba?
Building on some of the response received from our recent coverage on Chinese equities, there seems to be confusion around the delisting risks facing Alibaba still, with some investors believing that corporate management has a say in the evolving situation. However, it is important to understand that no matter how committed management is today with ensuring their listing in the U.S. stays active, the ultimate decision lies in the hands of both the Chinese and U.S. regulators – primarily the CSRC, SEC and the PCAOB.
The “Holding Foreign Companies Accountable Act” (“HFCAA”) signed into law in December 2020 was put in place to counter Beijing’s ongoing deflection of mandatory PCAOB inspections on corporate audits in mainland China and Hong Kong. Under the HFCAA, publicly listed companies that have engaged an auditor in a non-U.S. jurisdiction that fails to comply with PCAOB audit inspection requests will be delisted from American exchanges “after three consecutive years of being identified”. Today, only public auditors in mainland China and Hong Kong, which provides public accounting services to more than 160 publicly listed companies on U.S. exchanges, have failed to cooperate with PCAOB inspection requests.
For Alibaba, which was added to the SEC’s rolling list of “commission-identified issuers” on August 22, 2022 for engaging a non-compliant public accounting firm for its annual financial audits, the company has until August 22, 2025 for its auditor (PricewaterhouseCoopers Hong Kong) to conform with the PCAOB’s inspection requests to prevent removal from the NYSE. Despite the recent preliminary agreement reached between the SEC, PCAOB, CSRC and Ministry of Finance of the PRC (explained in detail in later sections), Alibaba’s valuation discount (further explained here) to its American counterparts with similar growth profiles reflects the prominence of delisting risks still – investors remain on edge about how the latest development will unfold, underscoring the long road ahead to rebuild the stock’s regulatory credibility.
And although Alibaba has paved one of the most attractive “next best options” for shareholders of its ADRs in the unlikely event of delisting from the NYSE, which permits the conversion of shares through its secondary listings on the HKSE that will later transition into a primary listing by year-end, the stock has yet to unlock greater upsides that are reflective of its fundamental growth profile. This is largely due to the difference in valuation advantages between the Asian and American stock markets, which we have discussed in previous coverages:
Although Alibaba’s listing on the Hong Kong Stock Exchange provides partial insulation from the SEC-imposed delisting risks by allowing an option to convert ADRs for Hong Kong-listed shares, it remains a less attractive option. The Asian exchange’s “less active and liquid markets” has two times less turnover on average compared to American exchanges, resulting in relatively mediocre valuation prospects compared to those of counterparts listed on the NYSE/Nasdaq… While Alibaba’s recent plans to pursue a primary listing in Hong Kong would open the door to incremental capital from mainland investors, related trading volumes remain a far cry from those in the U.S. – the average daily trading volume for Alibaba stocks in Hong Kong last month was about $700 million, compared to about $3.2 billion in the U.S.
Source: “Alibaba Stock: Does China’s Monetary Easing Offset the Regulatory Risks?” and “Alibaba is Still Not a Buy, Here’s Why“
What are PCAOB Inspections and How Do they Apply to Alibaba?
PCAOB inspections typically target 1) the public accounting firm performing the audit, and 2) the engagement that has been selected for evaluation – it is essentially as an “audit of an audit”:
1. Targeting the Public Accounting Firm
One reason for regular PCAOB inspections is to ensure public auditors have complied with GAAP rules in performing the audit of their clients’ respective financial information to ensure they are free from material misstatement whether due to error or fraud. Public accounting firms that provide an audit opinion for more than 100 publicly-listed companies are inspected by the PCAOB annually – these typically include the widely known firms such as Deloitte & Touche, Ernst & Young, KPMG, and PricewaterhouseCoopers. Meanwhile, smaller public accounting firms that provide audit opinions to less than 100 issuers are inspected once every three years. Special PCAOB inspections are also carried from time to time, and could target the audit engagements of a specific audit partner and/or industry group.
For Alibaba, this means its auditor – PricewaterhouseCoopers Hong Kong – will need to comply with PCAOB inspection requests and come out clean with no material findings to minimize repercussions on the stock’s long-term valuation prospects.
2. Targeting the Issuer
The selection process for specific audit engagements subject to PCAOB inspections combines “risk-based and random methods”. This essentially means audit engagements that exhibit a higher risk of material misstatement typically have a higher chance of getting selected for inspection. These include audits for issuers that are exposed to significant accounting estimates that require judgement (e.g. asset revaluation; share-based compensation revaluation), and material revenues (revenue recognition is deemed a default significant and fraud risk item under GAAP rules except under extraordinary circumstances), which Alibaba checks the boxes for. As one of the largest publicly listed companies in the U.S. with complex operations across multiple industries and geographic regions, Alibaba fits the bill for a high-risk engagement that potentially puts it higher on the PCAOB’s inspection watchlist compared to smaller businesses with a more straightforward business model (e.g. a single revenue-stream business earning fixed contracted revenues that can be easily substantiated).
However, the volume of audit inspections that the PCAOB decides to proceed with for the selected public accounting firm varies, again, based on risk factors considered. For instance, U.S.-listed Chinese stocks may be subject to greater inspection frequency and volume on an annual basis once the CSRC gives the full green light, considering the higher audit risk of inaugural inspections. Firms that were subject to higher reporting perils due to COVID disruptions, such as those exposed to significant collection risks, might have also been a prime cohort within the PCAOB’s attention during the 2019-2020 inspection years. For now, the PCAOB has yet to release any detail on whether or how it will conduct inspections on U.S.-listed Chinese companies found in the commission-identified issuers list, other than the fact that it will get the ball rolling by mid-September.
Essentially, PCAOB inspections target both the audit firm and specific audit engagements. However, U.S.-listed Chinese equities are potential victims to HFCAA primarily because of their auditors’ non-compliant status with PCAOB inspection requests under the Chinese government’s previous orders. This means the only way to dodge HFCAA delisting risks completely today is to switch to a registered public accounting firm that currently complies with PCAOB inspection requests (i.e. outside of mainland China / Hong Kong), which is not an easy feat – especially for Alibaba which has a sprawling business that is primarily China-based.
What is the August 26, 2022 Statement of Protocol and What Does it Mean for Alibaba?
In the latest development, Chinese authorities have finally agreed to PCAOB inspection requests mandated by the SEC last Friday (August 26th) under a “Statement of Protocol” signed between the related regulatory parties. Under the protocol, the PCAOB will be allowed to select its inspection candidates – both the public accounting firms and audit engagements – without consent or input from Chinese authorities. PCAOB inspectors will also gain complete access to unredacted working papers pertaining to audit engagements under inspection, and conduct direct interviews “from all personnel associated with the audits” of interest. The inspection process in mainland China and Hong Kong is set to begin in mid-September.
But as mentioned in the earlier section, the Alibaba stock’s rally immediately following the announcement was short-lived, staging a lackluster showing for what was thought to be a significant milestone. In addition to investors’ concerns over Alibaba’s near-term fundamental weakness due to the faltering Chinese economy and broad-based market share loss coming out of Beijing’s yearlong crackdown on big tech influence – which has been further corroborated by key rival JD.com’s (JD) recent revenue growth in contrast to Alibaba’s first quarterly revenue decline since becoming a publicly-listed company during the June-quarter – the stock’s failure to sustain a rally this week implies that investors are still looking for proof that it is out of the regulatory woods.
With the PCAOB calling the latest preliminary agreement a mere “first step” to validating China’s full compliance with SEC-mandated inspection rules, investors are now looking for proof that there has been no significant audit cover-up / fraudulent reporting across U.S.-listed Chinese stocks, proof that Beijing will not interfere with the audit inspection of more than 150 companies on the rolling commission-identified issuer list as promised in the protocol, and most importantly, proof that Alibaba makes the cut. But as mentioned in the earlier section, it is currently uncertain of how the PCAOB plans to execute the inspections. In fact, it could take years for the PCAOB to complete the inspection of selected audit engagements from the growing list of commission-identified issuers, and obtain sufficient comfort that Chinese regulators and registered public accounting firms in mainland China and Hong Kong are indeed compliant with requirements under the HFCAA – a remark that the PCAOB has specifically pinpointed on its fact sheet pertaining to the protocol. Until then, there is only so much control that Alibaba has over restoring its credibility as a viable long-term investment on the U.S. exchange.
Final Thoughts
Compared to the situation from a year ago, regulatory downside risks facing the Alibaba stock have in fact improved and are no longer outpacing its upside potential as much given the recent easing in Beijing’s regulatory woes as well as the latest development on HFCAA. Instead, the evolving situation has been reduced to a consistent “tug-of-war” today, where both risks and rewards are equally weighed, causing the stock to fluctuate rangebound.
Until there is greater certainty and evidence to support that the upsides outweigh the downside risks, which could still be years out considering uncertainties over the PCAOB inspection timeline – let alone other persistent headwinds such as Beijing’s regulatory crackdown agenda and broader macro uncertainties – the Alibaba stock will continue to have a hard time in finding ground for anchoring a sustained rally. With regulatory risks still capping the Alibaba stock from trading in parity to its American peers, we are maintaining our view that the shares will remain in flux within the $100-range in the near-term.
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